HONG KONG (MarketWatch) — The new year has got off to a miserable start for China, with Shanghai shares
SHCOMP, -1.05%
already down 22% and the yuan
USDCNH, +0.0421%
under the cosh amid continued capital outflows. We have not even seen out January, but this could be just the start.

No figures are available for capital outflows year to date, but there are plenty alternative indicators suggesting pain is intensifying as well as policy risk.

The latest is the attack on legendary investor George Soros by the Communist Party mouthpiece the Xinhua news agency, which shows policy makers are rattled. His main crime appears to be saying a “hard landing for the Chinese economy was unavoidable” and that he was shorting Asian currencies.

But Soros or other hedge funds hardly need to be clairvoyants to see that China is now the big short.

In the past week a leaked memo from the People’s Bank of China spelled out what many assumed — that its leaders are in a deep policy bind with no painless way out.

It told how officials were reluctant to trim bank reserves ratio — a key monetary policy stimulus tool in China — because of concerns this will just add to capital outflows. The “impossible trinity” — of maintaining an independent domestic monetary policy and a semi-fixed exchange rate having loosened capital account restrictions — is hitting home.

As I wrote a month ago, after a year of reversal for the yuan policy makers are now in uncharted territory, trying to juggle a controlled currency depreciation and also plug capital outflows.

This latest revelation removes any lingering belief that there was a “Beijing-put” or “big bazooka” in reserve this time around.

Instead as analysts at Daiwa have predicted, the policy options for China’s leaders under a scenario of persistent capital outflows boils down to a series of unpalatable choices — debt deflation or a currency crisis.

The former is the scenario where foreign reserves are used up to protect the currency value, contracting money supply and leading to adjustment through lower prices. Hong Kong experienced this between 1998 and 2003 as it maintained its dollar peg while Asian currencies devalued. While it was painful, the city-state was able to withstand deflation due to the strength of its banks.

Debt deflation for China’s highly leveraged corporate sector looks to be the worst of choices. Last year research by Autonomous Economic found that China was already off the charts when compared with credit growth in other major countries prior to financial crisis.

The latter option calls for adjustment through a steep one-off devaluation, big enough to curb capital outflows. This would put a big dent in ambitions for the yuan to be taken seriously as a reserve currency and send a jolt through corporations that had loaded up on debt dominated in U.S. or Hong Kong dollars. China’s leaders and population would also feel poorer in dollar terms.

These rough choices explain why in recent days a third policy option has surfaced, of imposing strict capital controls as an interim band aid.

That might appear the obvious option. After all, China’s sealed financial sector and capital account were credited with largely insulating it from the global financial crisis of 2008.

But today China’s economy, companies and people are much more plugged into the global financial system. A reversal is unlikely to be simple.

While China’s equity markets still have minimal foreign ownership, the yuan is now widely used abroad and traded in various offshore hubs. Chinese companies have also bought and borrowed heavily overseas. Last year Daiwa estimated the full extent of the carry-trade of dollar leverage into China was some $3 trillion.

Sealing the capital account will not just be difficult but it may only postpone or redirect the pain. This also widens the potential assets to short on China.

If investors cannot get money out of China due to capital controls, they might just sell Hong Kong dollars as a proxy.

If the Hong Kong peg does take the strain, expect it to be felt in the interbank market and in the property prices, given that the majority of recent mortgages in Hong Kong have been Hibor based.

Capital controls could bring trouble to other sectors. Chinese investors may find it more difficult to complete property purchases overseas in destinations from Sydney to London. China’s outbound tourism and travel industry could also be vulnerable given it runs a huge spending deficit.

Until Beijing can demonstrate a plan to restore confidence and growth, expect more short bets on China.

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